[BUY THE DIP?] Air Canada (TSE:AC)

AC is the flag carrier and the largest airline of Canada by fleet size and passengers carried. Founded in 1937, it provides scheduled and charter air transport for passengers and cargo to 207 destinations worldwide.

In the past three months, the coronavirus crisis caused the stock to crash from an all-time high of $52.03 CAD to a three year low of $12.41 CAD, a spectacular 76% decrease.

source: google

However, I believe that AC may recover lost ground once the situation returns to normal.

Here’s why.

STRONG EARNINGS GROWTH

AC’s Income Statement reveals consistent earnings growth, with revenues increasing 30% in the last 4 years. The company claims that revenue growth is due to “yield improvement of 4.6% and traffic growth of 1.9%“. The company’s EPS for the trailing twelve months (TTM) is 5.43 and its TTM P/E ratio is 2.29.

source: yahoo finance

POSITIVE CASH FLOW

Free Cash Flow is an indicator of the financial strength and performance of a business, indicating the amount of cash it is able to generate from operations and after capital expenditures. 

In 2019, AC’s FCF is $3.6 billion. AC’s FCF has increased significantly since 2016 and it was multiplied by 7.4 between 2018 and 2019. The company targets cumulative FCF of $4-$4.5 billion by 2021.

Free Cash Flow is important because it allows a company to pursue opportunities that enhance shareholder value.

source: yahoo finance

GOOD RETURN ON EQUITY

AC boasts very strong Return on Equity. However, this is nuanced by the company’s debt burden which I will talk about later.

Although the company’s Return on Investments and Return on Assets are low, they are superior to its industry peers, which is a very good sign. Indeed, you want to invest in the “best of breed” businesses whenever possible

STRONG PERFORMANCE
COMPARED TO ITS PEERS

  • The 5-year gross margin average of 55.63% is superior to the industry average of 51.96%;
  • The 5-year net profit margin average of 5.77% is superior to the industry average of 3.55%;
  • Revenue/share of 70.46 is double the industry average of 34.87;
  • Diluted EPS of 5.43 is vastly superior to the industry average of 1.53;
  • Book Value/Share of 16.68 is more than double the industry average of 7.6;
  • Cash/Share of 22.32 is almost triple the industry average of 8.12;
  • Cash Flow/Share of 12.68 is triple the industry average of 4.24.

WHAT I DON’T LIKE: THE LIABILITIES

In my opinion, the biggest risk lies in the company’s debt burden. Indeed, the Current Ration (CR) and the Debt/Equity (D/E) ratios indicate that the company may have difficulty honoring its obligations if it encounters prolonged economic difficulties:

  • The Current Ratio of 0.96 is poor: The company has insufficient short term assets to cover its short term liabilities. Warren Buffet likes to invest in businesses who have a CR equal or superior to 1.5. AC fails this test.
  • The Debt/Equity Ratio of 5.3 is very poor: The company’s total equity is insufficient to cover its total liabilities. Warren Buffet likes a D/E ratio inferior to 0.5. AC also fails this test.
source: yahoo finance
source: yahoo finance

Obviously, investors prefer low debt ratios. In normal economic conditions, significant debt burdens are part and parcel of investing in airlines as they are a high-volume, low-margin business with significant capital expenditures.

However, in this extraordinary economic climate, my concern is that AC’s $8 billion of long term debt could become a problem as their cash flow dries up.

CONCLUSION

If you like airlines, now is a reasonable time to start looking over different investment opportunities. However, you must not downplay the seriousness of the coronavirus situation:

  • The global economy is slowing down as many countries are in complete shutdown;
  • The tourism industry is at a standstill and this affects the revenues and long-term survival of airlines, cruise ship companies, restaurants, hotels and general commerce;
  • The virus is not under control and the global economy may remain lethargic for some time;
  • The stimulus measures by no means guarantee that companies will survive and prevent layoffs;
  • Once the crisis is over, the tourism industry will probably not pick up where it left off as thousands of businesses may close and millions of workers may lose their jobs.

That being said, people will start traveling again for reasons other than tourism once the crisis is over. AC is one of the world’s leading airlines and it will start generating revenue again if they can survive the current situation.

RECOMMENDATIONS

  • Investors who want to buy this stock should spread their purchases over several months to hedge against the possibility of a continued decline in the stock’s price. The worse may be yet to come and you may be trying to catch a falling knife.
  • Consequently, I recommend dollar-cost averaging over the next 12-18 months.
  • This is a risky play given the economic context but a 24 months price target of $30 represents a potentially sizeable 150% gain.
  • Keep an eye on how the company manages its debt burden.

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Disclaimer: This is not financial advice. Do your own research before investing in any asset.

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